Understanding Auctions

Srobonti Chattopadhyay, Rittwik Chatterjee

• Publisher: Routledge
• Year: 2019
• ISBN:
  9781351271066
• Edition: 1
• Topic: Negocios y empresa
• Subtopic: Comercio electrónico

The book elaborates the basic principles of Auction Theory in a non-technical language so as to make them easily accessible to even those not trained in the discipline. Auctions as allocation mechanisms have been in use across the world since antiquity and are still employed in different countries for purchase and sales of a wide range of objects, both by governments and by private agents. Auction has gained popularity over other allocation mechanisms since the rules of auctions are very precise, involve much less subjective judgements compared to other alternative allocation mechanisms and lead to a more efficient process of discovering the true willingness of the buyers to pay. Moreover, the principles of Auction Theory are used in other contexts, for examplein designing contests, or in controlling emission levels through allocation of permits and licenses.

1 What are auctions, and what is Auction Theory?

The word auction is more or less familiar to almost everyone in today’s world. Very often daily newspapers carry reports on auctions of various types of public resources; at times there are advertisements, both from private concerns as well as from government bodies, calling for tenders for auction of some particular object(s) or the other. Advertisements or information about auctions are also common on websites. In many areas across the world, auction houses conduct auctions at fixed intervals of time, e.g., regularly on a weekly, fortnightly or monthly basis. We came across instances of auctions even in storybooks in our childhood.¹ Thus, almost everybody has a notion of what auctions mean. If asked, the first most likely answer to come from anyone selected at random is that auctions involve a situation where many people are trying to buy a particular object, and the seller of that object is asking for the price that each of the interested buyers is willing to pay; the buyers call out their prices, and in the process, the prices are driven upwards till the point where only one interested buyer remains. This is our most common perception about auction. However, this is just one form of auction, popularly known as English Auction and technically classified as open ascending auction.

So how do we actually define auctions? Auctions can be defined as market institutions with an explicit set of rules determining resource allocation and prices on the basis of bids from the market participants. The word auction is derived from the Latin word augere, which means augmenting.² In another opinion, the word auction originates from the Latin word aucus, which means increase.³ Both these ideas point to the increasing trend in prices in the auctions. In most instances, auctions involve rising prices and therefore the name. But it must be noted that not all auctions follow this rule. Also, for most auctions, buyers are the bidders; however, even this rule has exceptions. For example, in the case of procurement auctions, the sellers are the ones who submit bids.

Although used widely in the present world, auction as an allocation mechanism has a rich history. We next provide a quick look at auctions in the historical perspective.

A historical perspective on auctions

Auctions as market institutions have existed since antiquity as a very useful allocation mechanism. As noted by Cassady (1967), a large variety of objects used to be sold through auctions in ancient times. Instances of auctions can be traced back to as early as 500 B.C.E. Herodotus mentions that marriage used to be conducted through auctions in Babylon during this era.⁴

In ancient Rome, auctions were used to a certain extent for commercial trade. The rules and modus operandi of these Roman auctions are not clearly known, but it seems that samples of goods were displayed in a particular place prior to their sale. However, whether the bidding process was of ascending or descending type or of any other type totally different from these is unknown. But the bids were likely to be of increasing type (meaning that the bids are higher for higher types of bidders and lower for bidders of lower types). Four types of agents were involved in these auction processes: one, on whose behalf the object was sold; another, who organised, regulated and possibly financed the auction sale; a third, who advertised, promoted the auctions and conducted the biddings; and finally the one who purchased the goods, being the highest bidder. The Roman Empire, it appears, used to host auctions of many other diverse types of objects. For example, during financial hardships, some people used to sell their furniture or ornaments through auction. It is said that in order to cover a deficit, some royal heirlooms and furniture were once offered for sale through auctions. The Roman soldiers also used to hold auctions in order to sell the proceeds of their loots during wars (sometimes even slaves were sold through auctions). This, it is believed, encouraged businessmen to accompany the military expeditions “in order to bid in the war booty at public auctions”.

The strangest auction in history is probably the auction of the Roman Empire. The Praetorian Guard decided to sell off the whole of the Roman Empire through auction, after killing the Emperor Pertinax in 193 C.E. The highest bidder was promised that he would be awarded the crown. Didius Julianus, who agreed to pay 25,000 sesterces, or 6,250 drachmas per person, was the winner and therefore the emperor. However, he ruled for only two months and was beheaded by the insurgent groups headed by Septimius Severus, who then seized the capital. This is regarded as the earliest and most extreme case of “winner’s curse”.

Auctions were also used by Buddhist temples and monasteries in ancient China, as early as the seventh century C.E. The belongings of the deceased monks were offered for sale through auctions, and the proceeds were donated to the temples or monasteries. However, not much is known about the rules and methods of these auctions. Apparently, the auctioneer (usually a monk) had to know the normal price of the objects up for sale and had to provide details regarding the quality of these objects, e.g., whether old, new or worn out etc.

In England, auctions were also widely used. The historical accounts confirm that towards the end of the seventeenth century, sellers of pictures used to hold auctions in coffeehouses or taverns. Certain types of merchandise trade, the sale of properties of people who had gone bankrupt, the sale of estates and pieces of land etc. were also conducted through auctions. Whatever little information regarding the auctions in England in the old days is available suggests that the rules of auction were somewhat similar to those used at present. Sotheby’s, the world-famous auctioneer company, was established in 1744, and another no less renowned auctioneer company, Christie’s, was founded in 1766.

Auctions, like many other ideas and institutions, traveled to America with the emigrants from England. The colonisers, during their early days in America, used auctions for disposing of properties under the judicial process, to close out stocks of merchandise, to liquidate capital goods and inventories, to unload unsalable goods in the importer’s possession at the end of the season, to sell second-hand furnishings, utensils, domestic animals etc. Before the American Civil War, even slave trade was largely conducted through auctions in the Old South.

In countries like the Netherlands, Germany, Japan, Hong Kong etc., auctions came to be used much later. During the second half of the nineteenth century, the auctioning of fish and produce developed in Germany and the Netherlands, respectively. In countries like Japan and Hong Kong, auction became a predominant mode of transaction, mostly as a part of the market reform that aimed at replacing the existing feudalistic structure in which the producers or primary sellers were largely exploited by the ruling authority.

In addition to fish auctions, the Netherlands has also been known for the Dutch flower auctions. Since the end of the nineteenth century, flower products in the Netherlands used to be marketed through the Dutch Auction mechanism. The flower growers during that time used to form a cooperative and developed their own local marketplace. The Netherlands remains the world’s leading producer and distributor of cut flowers:

The Dutch dominated the world export market for cut flowers in 1996 with a 59 per cent share and for potted plants with a 48 per cent share. The world’s two biggest flower auctions are in Aalsmeer (VBA) and Naaldwijk/Bleiswijk (BVH); every day on average 30 million flowers – originating not only from the Netherlands but also from countries such as Israel, Kenya and Zimbabwe – are traded in 100,000 transactions. The Dutch flower auctions play a vital role in Holland’s leadership of this industry, by providing efficient centers for price discovery and transactions of flowers between buyers and sellers. These auctions traditionally use the “Dutch auction” as the mechanism for price discovery. They are established as cooperatives by the Dutch growers. The following auction rules characterize the Dutch flower auction concept, see also Van Heck et al. (1997). Dutch flower auctions use a clock for price discovery, as follows. The computerized auction clock in the room provides the buyers with information on producer, product, unit of currency, quality, and minimum purchase quantity. The flowers are transported through the auction room, and are shown to the buyers. The clock hand starts at a high price determined by the auctioneer, and drops until a buyer stops the clock by pushing a button. The auctioneer asks the buyer by intercom, how many units of the lot he or she will buy. The buyer provides the number of units. The clock is then reset, and the process begins for the left-over flowers, sometimes introducing a new minimum purchase quantity, until all units of the lot are sold. In the traditional way buyers must be present in the auction room. In practice, it turns out that the Dutch flower auction is an extremely efficient auction mechanism: it can handle a transaction every four seconds.⁵

A very different type of auction has been discussed by Sen and Swamy (2004), which they term taxation by auction. This basically refers to a practice that was in use during the end of the nineteenth and early twentieth centuries in Gujarat, India. The state of Gujarat, located in the western part of India, has for quite some time been a major centre of manufacturing and trading. The producers/traders involved in any common line of business in a city in this region used to form associations known as Gujarati guilds. As Sen and Swamy (2004, p. 134) observe:

Like any professional association, the guilds sought to raise funds from their members for internal use, such as organizing dinners for guild members. In addition, the richer guilds collected funds to provide various community-wide public goods and services… . To raise funds, many Guilds employed a mechanism that the Gazetteer of the city of Surat, a prominent Gujarati trading and manufacturing center described as follows (Bombay Presidency 1877, p. 321): “A favorite device for raising money is for the men of craft or trade to agree, on a certain day, to shut all their shops but one. The right to keep open this one shop is then put up to auction, and the amount bid is credited to the guild fund.”

Sen and Swamy (2004) theoretically analyse this mechanism and conclude that, under certain conditions, not only was this taxation by auction mechanism preferred by a majority of guild members over the conventional taxation mechanism, but also this mechanism ensures more equity socially compared to conventional taxation.

Thus auctions have been in practice for quite some time in different parts of the globe and in different forms for addressing a vast majority of issues and selling varied types of objects. They have evolved over time and are still evolving. Auction as an allocation mechanism is increasingly being adopted for the allocation of natural resources, especially scarce ones, across countries. The most remarkable examples are those of telecom spectrum licenses, licenses for mining rights, Treasury bills etc. Many new auction rules are still being devised to address the needs of contemporary times. With the development of technology, the ways of conducting auctions are also transforming. This is quite visible even in some traditional auctions. For example, in September 1994, through a referendum, the flower growers in the Dutch flower industry, who are also owners of the auctions, decided to ban foreign grower participation to reduce foreign access to the traditional Dutch Auctions. This in turn prompted the development and introduction of Tele Flower Auction (TFA) as one of the initiatives in response to import restrictions by the traditional Dutch flower auctions.

TFA is an electronic alternative that enables buyers to trade at a distance; this alternative is currently exploited by an import organization called East African Flowers (EAF).⁶Van Heck et al. (1997) show that: IT enables new ways of competition and coordination, thus changing the ways in which individuals and organizations exchange goods and services. It also shows the globalization of the flower market, and the increasing cross-border competition.

Different types of auctions

Auctions can be of different types depending on their rules. The classification of auctions can be done in many different ways, e.g., open bid vs. sealed bid auctions, single stage vs. multistage or sequential auctions, private value vs. common value auctions etc. Within these categories, further subcategories exist. Also, some auction rule share some aspects of each category.

As the name suggests, open bid auctions are auctions for which the bidders call out their bids publicly, so that everyone present gets to know these bids while the auction is still going on. Sealed bid auctions, on the other hand, are auctions in which the bidders submit their bids in sealed envelopes. Here, only the auctioneers get to observe the submitted bids before declaring the winner. Usually the auctioneers have discretion to disclose, partly disclose or totally suppress information about submitted bids. For single object auctions, bid disclosure policy does not make any difference in the bidding behaviour. However, for multiple object auctions, the extent to which information about previous rounds is disclosed results in totally different bid functions in subsequent rounds.

Open bid auctions can be of the ascending or descending type. The auctions where the prices are driven up gradually are termed ascending price auctions or simply ascending auctions. As noted earlier, what is popularly known as English Auction is an open ascending auction. These auctions may involve a single object or a multitude of objects. Thus we may have single object English Auction or multi-object English Auction, depending on how many objects are up for sale. In case of a single object English Auction, the auction starts either by inviting bids from the bidders directly or by the auctioneer quoting a low price and asking how many bidders are willing to pay that bid. In the former case, bids are invited from the bidders continuously, and in the process the bid values keep on increasing, some bidders dropping out at several points, till the bid value reaches a level where only one bidder remains who is willing to buy the object at the quoted bid. This bidder is declared to be the winning bidder. In the latter case, the auctioneer keeps enhancing the bid value by a predetermined increment amount and continues to do so till all bidders except one drop out. The multi-object English Auction is similar in principle except for the single difference that that here...